Saturday, November 29, 2008

Greenspan Recants (or did he?)

The current financial crisis is an interesting real-life experiment to free market fans like me. It’s far too early to draw conclusions, but much of the generally accepted wisdom right now is that “pure capitalism” has failed and that the world needs more regulated markets to protect against “excess” and prevent or lessen these crises in the future.

But my belief in free markets is more about information than it is about money. Most regulations involve one person (a bureaucrat) telling another person (you or me) what to do. Sometimes that’s necessary: for example we’re all better off when a central planner decides that everyone must drive on the right-hand side of the road. But for this to be effective, bureaucrats need to be humble about their terrible disadvantage in information. No regulator can possibly know as much as you do about your individual circumstances, and this information disparity is the source of why regulation often causes more harm than help.

Those of us who believe this idea have long thought of Former Federal Reserve Chairman Alan Greenspan as an ally, so I was intrigued when I saw news reports (now repeated over and over) that he “changed his mind”.

Except, he didn't. When I look at the actual transcripts, it's clear to me that careless news reporters have simply spun his remarks incorrectly. Here's the key quote:

Chairman WAXMAN. Well, where did you make a mistake then?

Mr. GREENSPAN. I made a mistake in presuming that the self-interest of organizations, specifically banks and others, were such is that they were best capable of protecting their own shareholders and their equity in the firms.

And it's been my experience, having worked both as a regulator for 18 years and similar quantities, in the private sector, especially, 10 years at a major international bank, that the loan officers of those institutions knew far more about the risks involved and the people to whom they lent money, than I saw even our best regulators at the Fed capable of doing. So the problem here is something which looked to be a very solid edifice, and, indeed, a critical pillar to market competition and free markets, did break down. And I think that, as I said, shocked me. I still do not fuIly understand why it happened and, obviously, to the extent that f figure out where it happened and why, I will change my views. If the facts change, I will change.

What follows is his attempt to defend himself against the implication that somehow he was derelict at his duties as Fed Chairman, that ideology got in the way of his performing his legal responsibilities. As someone who obviously cares about integrity, much of Greenspan's testimony is simply responding to those charges, which he thinks are unfair.

But he eventually reaches his bottom line:

Mr. GREENSPAN. I think that it's interesting to observe that we find failures of regulation all the time, and one of the reasons is a very significant amount of regulation in the economic area is based on a forecast to know in advance whether or not particular products will go bad or the cycle will turn. If we are right 60 percent of the time in forecasting, we're doing exceptionally well. That means we are wrong 40 percent of the time, and when you observe the extent of the broad failure, the difficulty is that nobody can forecast. If you try to take a look at what the private sector does it's precisely the same thing that goes on in government. We at the Federal Reserve had a much better record forecasting than the private sector, but we were wrong quite a good deal of the time and that is reflected in how one views what the appropriate regulatory authorities are because unless you can anticipate the types of problems that are going to happen, it's very difficult to know what to do. And I think that's the problem that this type of thing confronts and I don't see any way in which that's going to be fundamentally changed. We can try to do better, but forecasting is never--never gets to the point where it's 100 percent accurate.

When you look at his entire testimony, it's clear that Greenspan in no way has changed his mind or even modified his fundamental pro-market position. He maintains his strong support for an unregulated market in derivatives, for example, which "are working well" (his quote). The part he doesn't understand (where he'll change his mind if the facts change) relates to credit default swaps--a market that barely existed when Greenspan was chairman and therefore was impossible to forecast. And who would we be regulating anyway? He reminds us of this:

"We are not dealing with people who are dumb. We are dealing with, by far, the most sophisticated, thoughtful people about the way markets work who created the major problems".

Enacting regulations to prevent a future collapse of the credit default swaps market would be a waste of time, since (as Greenspan notes) nobody is interested in that market anymore now anyway. But enacting other regulations would simply hamper a market that is already working well 60% of the time. Does anybody think they can get better odds on an alternative system? Exactly which regulations would you enact that would improve upon that record? Greenspan doesn't recant: he just admits he doesn't know. Do his regulation-happy opponents or the careless reporters know? Do you?

No comments:

About Me

Years building software and marketing teams at Apple, Microsoft, and startups in the US, Japan, and China have given me an awareness of how little I know, but at least I try to write it down before I forget.